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MB0029 set-2

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Program MBA 2nd sem– Lateral Entry

Subject Financial Management, set(2)

Code MB 0029

Centre

Q1. Is Equity Capital Free of cost? Substantiate your statement.

Ans. No. Equity Capital is not free of cost. Some people are of the opinion

that equity capital is free of cost for the reason that a company is not legally

bound to pay dividends and also the rate of equity dividend is not fixed like

preference dividends. This is not a correct view as equity shareholders buy

shares with the expectation of dividends and capital appreciation. Dividends

enhance the market value of shares and therefore equity capital is not free

of cost.

Equity shareholders do not have a fixed rate of return on their investment.

There is no legal requirement (unlike in the case of loans or debentures

where the rates are governed by the deed) to pay regular dividends to them.

Measuring the rate of return to equity holders is a difficult and complex

exercise. There are many approaches for estimating return - the dividend

forecast approach, capital asset pricing approach, realized yield approach,

etc. According to dividend forecast approach, the intrinsic value of an equity

share is the sum of present values of dividends associated with it.

Q2.(a) What is the rate of return for a company if the β is 1.25, risk

free rate of return is 8% and the market rate of return is 14%. Use

CAPM model.

Ans.

Ke = Rf + β (Rm—Rf)

= 0.08 + 1.25(0.14 - 0.08)

= 0.08 + 0.075

= 0.155 or 15.5%

12% preference share capital Rs.100 each 100 lakhs

Retained earnings 150 lakhs

12% Debentures (Rs.100 each) 350 lakhs

14% Term loan from SBI 150 lakhs

Total 1000 lakhs

The market price per equity is Rs 54. The company is expected to declare a

dividend per share of Rs.2 per share and there will be a growth of 10% in

the dividends for the next 5 years. The preference shares are redeemable

at a premium of Rs.5 per share after 8 years. The current market price of

preference share is Rs.92. Debenture redemption will take place after 7

years at a discount of 2% and the current market price is Rs.91 per

debenture. The corporate tax rate is 40%. Calculate WACC.

(7 Marks)

Ans.

Ke is the cost of external equity,

D1 is the dividend expected at the end of year 1 = 2

P0 is the current market price per share = Rs. 92

g is the constant growth rate of dividends = 10%

f is the floatation costs as % of current market price.

Ke =( D1/P0) + g

= (2/54) + 0.1

= 0.137 or 13.7%

Kp = D + {(F—P)/n} / (F+P)/2

3 Roll No: 540910912

D is the preference dividend per share payable=11

F is the redemption price=105

P is the net proceeds per share = 92

n is the maturity period =8

Kp = D + {(F—P)/n} / (F+P)/2

= 11 + (105—92)/8] / (105+92)/2

=12.625/98.5

= 0.1281 or 12.81%

Kr=Ke which is 13.7%

Cost of debentures:

Kd = [I(1—T) + {(F—P)/n}] / {F+P)/2}

Where Kd is post tax cost of debenture capital,

I is the annual interest payment per unit of debenture,

T is the corporate tax rate = 40%

F is the redemption price per debenture = Rs. 98

P is the net amount realized per debenture = Rs. 91

n is maturity period = 7 years

= [12(1—0.4) + (98—91)/7] / (98+91)/2

= [7.2 + 1] / 94.5

= 0.0867 or 8.67%

Kt = I(1—T)

=0.14(1—0.4)

= 0.084 or 8.4%

We = 250/1000 = 0.25

Wp = 100/1000 = 0.1

Wr = 150/1000 = 0.15

Wd = 350/1000 = 0.35

Wt = 150/1000 = 0.15

4 Roll No: 540910912

Step III Multiply the costs of various sources of finance with corresponding

weights and WACC calculated by adding all these components.

WACC = WeKe + WpKp +WrKr + WdKd + WtKt

= (0.25*0.137) + (0.1*0.1281) + (0.15*0.137) + (0.35*0.0867) +

(0.15*0.084)

= 0.03425+ 0.01281+ 0.02055+ 0.030345+ 0.0126

= 0.043 + 0.023 + 0.022 + 0.0384 + 0.004

= 0.1105 or 11.05%

Q3. The effective cost of debt is less than the actual interest

payment made by the firm. Do you agree with this statement? If

yes/no substantiate your views.

Ans. Yes. The debentures carry a fixed rate of interest. Interest qualifies for

tax deduction in determining tax liability. Therefore the effective cost of debt

is less than the actual interest payment made by the firm.

The Net Cash Outflows in terms of Amount of Periodic interest Payment and

Repayment of Principal in Installments or in lump-sum on Maturity.

The Interest Payment made by the firm on Debt Issues qualifies for tax

deduction in determining the net taxable income. Therefore, the effective

cash outflow is less than the actual payment of Interest made by the firm to

the debt holders by the amount of tax shield on Interest Payment. The debt

can either be Perpetual/Irredeemable or Redeemable.

managers?

Ans. There are many reasons that make the Capital budgeting decisions

the most crucial for finance Managers:

flows in future. For example, investment in plant and machinery. The

economic life of such assets has long periods. The projections of cash flows

anticipated involve forecasts of many financial variables. The most crucial

variable is the sales forecast.

a. For example, Metal Box spent large sums of money on expansion of its

production facilities based on its own sales forecast. During this period,

5 Roll No: 540910912

huge investments in R & D in packaging industry brought about new

packaging medium totally replacing metal as an important component of

packing boxes. At the end of the expansion Metal Box Ltd found itself that

the market for its metal boxes had declined drastically. The end result is

that Metal Box became a sick company from the position it enjoyed

earlier prior to the execution of expansion as a blue chip. Employees lost

their jobs. It affected the standard of lining and cash flow position of its

employees. This highlights the element of risk involved in these type of

decisions.

on expansion through the addition of new products and adoption of the

latest technology creating wealth for shareholders. The best example is

the Reliance group.

c. Any serious error in forecasting Sales and hence the amount of capital

expenditure can significantly affect the firm. An upward bias may lead to

a situation of the firm creating idle capacity, laying the path for the

cancer of sickness.

losing its market to its competitors. Both are risky fraught with grave

consequences.

2. A long term investment of funds some times may change the risk profile

of the firm. A FMCG company with its core competencies in the business

decided to enter into a new business of power generation. This decision will

totally alter the risk profile of the business of the company. Investor’s

perception of risk of the new business to be taken up by the company will

change his required rate of return to invest in the company. In this

connection it is to be noted that the power pricing is a politically sensitive

area affecting the profitability of the organization. Therefore, Capital

budgeting decisions change the risk dimensions of the company and hence

the required rate of return that the investors want.

3. Most of the Capital budgeting decisions involve huge outlay. The funds

requirements during the phase of execution must be synchronized with the

flow of funds. Failure to achieve the required coordination between the

inflow and outflow may cause time over run and cost over run. These two

problems of time over run and cost over run have to be prevented from

occurring in the beginning of execution of the project. Quite a lot empirical

examples are there in public sector in India in support of this argument

that cost over run and time over run can make a company’s operations

unproductive. But the major challenge that the management of a firm

6 Roll No: 540910912

faces in managing the uncertain future cash inflows and out flows

associated with the plan and execution of Capital budgeting decisions.

products and services, deciding on the scale of operations, selection of

relevant technology and finally procurement of costly equipment. If a firm

were to realize after committing itself considerable sums of money in the

process of implementing the Capital budgeting decisions taken that the

decision to diversify or expand would become a wealth destroyer to the

company, then the firm would have experienced a situation of inability to

sell the equipments bought. Loss incurred by the firm on account of this

would be heavy if the firm were to scrap the equipments bought specifically

for implementing the decision taken. Sometimes these equipments will be

specialized costly equipments. Therefore, Capital budgeting decisions are

irreversible.

of time. A firm incurs Capital expenditure to build up capacity in

anticipation of the expected boom in the demand for its products. The

timing of the Capital expenditure decision must match with the expected

boom in demand for company’s products. If it plans in advance it may

effectively manage the timing and the quality of asset acquisition. But

many firms suffer from its inability to forecast the future operations and

formulate strategic decision to acquire the required assets in advance at

the competitive rates.

three elements are cost, quality and timing. Decisions must be taken at the

right time which would enable the firm to procure the assets at the least

cost for producing the products of required quality for customer. Any lapse

on the part of the firm in understanding the effect of these elements on

implementation of Capital expenditure decision taken will strategically

affect the firm’s profitability.

World Trade organization. General Electrical can expand its market into

India snatching the share already enjoyed by firms like Bajaj Electricals or

Kirloskar Electric Company. Ability of G E to sell its products in India at a

rate less than the rate at which Indian Companies sell cannot be ignored.

Therefore, the growth and survival of any firm in today’s business

environment demands a firm to be proactive. Proactive firms cannot avoid

the risk of taking challenging Capital budgeting decisions for growth.

Therefore, Capital budgeting decisions for growth have become an

essential characteristics of successful firms today.

7 Roll No: 540910912

8. The social, political, economic and technological forces generate high

level of uncertainty in future cash flows streams associated with Capital

budgeting decisions. These factors make these decisions highly complex.

decisions firm’s will have to tap the Capital market for funds. The

composition of debt and equity must be optimal keeping in view the

expectation of investors and risk profile of the selected project.

expected to generate the following cash flow in the form of toll tax

recovery.

Year Cash Inflows

1 4,50,000

2 4,25,000

3 3,00,000

4 3,50,000

What is the IRR of the project?

Ans.

To calculate Internal Rate of Return (IRR):

Step I: Compute the average of annual cash inflows

Rs.

1 4,50,000

2 4,25,000

3 3,00,000

4 3,50,000

Total 15,25,000

Step II: Divide the initial investment by the average of annual cash inflows:

=10,00,000 / 3,81,250

=2.622

Step III: From the PVIFA table for 4 years, the annuity factor very near to

2.622 is 20%. Therefore

the first initial rate is 20%

Year Cash flows PV factor at 20% PV of Cash

8 Roll No: 540910912

1 4,50,000 0.833 3,74,850

2 4,25,000 0.694 2,94,950

3 3,00,000 0.579 1,73,700

4 3,50,000 0.482 1,68,700

Total 10,12,200

Since the initial investment of Rs.10,00,000 is less than the computed value

at 20% of

Rs. 10,12,200 then next trial rate is 22%.

1 4,50,000 0.82 3,69,000

2 4,25,000 0.672 2,85,600

3 3,00,000 0.551 1,65,300

4 3,50,000 0.451 1,57,850

Total 9,77,750

10,12,200 (20%), the IRR by interpolation is,

= 20 + 0.3541 *2

= 20.70%

Ans. Sensitivity Analysis:

There are many variables like sales, cost of sales, investments, tax rates etc

which affect the NPV and IRR of a project. Analysing the change in the

project’s NPV or IRR on account of a given change in one of the variables is

called Sensitivity Analysis. It is a technique that shows the change in NPV

given a change in one of the variables that determine cash flows of a

project. It measures the sensitivity of NPV of a project in respect to a

change in one of the input variables of NPV.

The reliability of the NPV depends on the reliability of cash flows. If fore

casts go wrong on account of changes in assumed economic environments,

reliability of NPV & IRR is lost. Therefore, forecasts are made under different

economic conditions viz pessimistic, expected and optimistic. NPV is arrived

at for all the three assumptions.

1. Identification of variables that influence the NPV & IRR of the project.

2. Examining and defining the mathematical relationship between the

variables.

3. Analysis of the effect of the change in each of the variables on the NPV of

the project.

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